Should Fund Managers Care About the Behavior Gap?

In their book, Quantitative Value, authors Tobias Carlisle and Wes Gray discuss the importance of creating an investment process that systematically reduces irrational behavior. Intelligent people are constantly looking for ways to minimize their own weaknesses. Automating good decisions is one of the best ways to pull this off.

There was one example in the book that showed just how much damage poor behavior can inflict on investor performance. Through 2009 Ken Heebner’s CGM Focus Fund was the best performing U.S. stock mutual fund of the decade. This was the hot mutual fund at the time that everyone was talking about. The performance of the fund was phenomenal, but there’s a catch — investors weren’t brought along for the ride. Here’s Gray and Carlisle on what happened (emphasis mine):

Over the decade, the fund had gained 18.2 percent annually, beating its closest rival by 3.4 percent per year, which is exceptional. The typical investor in Heebner’s fund, however, lost 11 percent annually. […] Heebner’s fund surged 80% in 2007, and then investors poured in $2.6 billion. The following year, the fund sunk 48 percent, and investors yanked out more than $750 million.

That’s a behavior gap of almost 30% per year. When asked about this enormous difference between investment and investor returns, here’s what Heebner had to say:

A huge amount of money came in right when the performance of the fund was at a peak. I don’t know what to say about that. We don’t have any control over what investors do.

This brings up an interesting dilemma for fund managers. How much responsibility should they take for their investor’s behavior? Shouldn’t they care about how their shareholders perform? Obviously, this is an extreme case, but I don’t think that fund managers should be so indifferent about investor performance.

Investors make their own decisions and there’s no way to stop irrational behavior in everyone, but asset management organizations have to educate their clients. There are ways in which funds can help educate their investor base. Communication of the investment process and potential opportunities or risks can help. This could include things like periodic outlooks, performance review letters, conference calls or webinars. Many fund shops have even set up their own blogs to share their thoughts and research on a regular basis.

Whatever the tool used, clear communication should be a priority for those investment firms that would like to distinguish themselves from asset-gathering marketing organizations. The investment firms that I like to work with are always excellent communicators. They’re honest and forthright with their investment process and views on the markets. This includes owning up to mistakes when they’re made and not making excuses for poor performance. Great analysis is worthless without the communication skills necessary to explain it.

The education and coaching aspects should be a priority for all investment organizations — financial advisors, fund managers, pensions, consultants, etc. — that invest funds on behalf of their clients. Nothing is perfect and you can’t save everyone from themselves, but it’s a helpful way to spread your message, gain the trust of clients and affect change in their behavior.

Source:
Quantitative Value

Find Tobias (@Greenbackd) & Wes (@alphaarchitect) on Twitter.

Further Reading:
Managing Someone Else’s Emotions
The Difference Between an Investment Firm & a Marketing Firm
Q&A With Alpha Architect’s Wes Gray Part I and Part II